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30/09/2020 – Agreements before your formal agreement: Understanding the purpose and impact of Memorandums of Understanding and Letters of Intent

In a perfect world, a design consultant would not proceed to perform services on a project until a full and complete written contract had been entered into and signed by both parties. The benefits of doing just that are significant and include being certain of your rights, obligations and liabilities, having a detailed brief and scope of services, provisions on dispute resolution and termination and the clear and established understanding that you have entered into a legally binding and enforceable agreement on considered, and complete terms. However, as we see all too often, sometimes it is not commercial or practically desirable to do so. In these circumstances, a number of documents may appear before the formal contract between the parties with various meaning, content and enforceability that can be hard to work out the value or purpose of. Two such documents we come across are memorandums of understanding and letters of intent.

MOU and LOI’s

A memorandum of understanding (MOU) or letter of intent (LOI) are preliminary written agreements, setting to outline the main broad terms of the relationship to be later included within a formal contract. They often record the party’s intention to enter into a contract, subject to agreement on the precise terms.

You might see this for example in a pre-tender bid between say a lead consultant or builder and subsequent design consultant. It lies somewhere between a formal written contract and a handshake deal.

For example, a builder and a design consultant may write an MOU to initiate professional services, stating how they will work together to achieve mutual goals. They do not need to have agreed upon pricing, formal scope or the standard of services yet.

One of the main benefits of these sorts of preliminary agreements are that by setting out the broad-brush main terms to be included later on, this helps to establish mutual goals and expectations, and to ensure all parties are on the same page avoiding confusion or miscommunications.

Each MOU or LOI is unique and might include things such as:

• the purpose of the commercial relationship;
• the role of each party;
• common goals of the parties; and
• how disputes might be resolved between the parties.

Are these preliminary agreements legally binding?

Each year, Australian courts hear many disputes as to whether these preliminary agreements, whereby the parties are entering into a further, more formal agreement, are binding.

In Australian law, following Masters v Cameron (1954) 91 CLR 353, it has been held that agreements to agree or contracts intending to make future contracts where the terms have not yet been ascertained, are not legally enforceable. Although a MOU or LOI is not necessarily legally binding, they most certainly can be.

In determining whether these preliminary agreements are binding, consideration will be given to:

• the surrounding circumstances and actions of the parties;
• the intention of the parties to form a legal relationship whether when entering a MOU or LOI, i.e. whether the parties want to merely express an intention to enter into a contract (probably non-binding), or actually enter into an agreement of sorts for the performance of certain services whilst the contract is being finalised (binding); and
• Whether or not the MOU or LOI was sufficiently clear to be legally binding.

Some examples of circumstances evidencing the parties intention to be bound might include prolonged discussions between the parties, seeking legal, insurance and/or other commercial advice and the recording of the promises between the parties. Importantly, by signing these preliminary agreements, this does not necessarily mean that you intend to be legally bound, but usually rather your intention to clarify goals and the commercial relationship.

Furthermore, obligations under an MOU or LOI are not likely to be binding on the parties if the obligations are expressed to be “subject to contract” or “on the usual terms” because the agreement between the parties is too vague and not sufficiently or clear for courts to enforce. However, it is important to make clear that you are not in fact accidentally creating a binding MOU. If its content resembles that of a more formal contract, it may be considered a different form of agreement which is legally binding and therefore enforceable (even it if states that it is not binding).

Interestingly, in Factory 5 Pty Ltd v State of Victoria [2010] FCA 1229 although the trial judge had found that the preliminary agreement was legally binding, when the matter was heard on appeal by the Full Federal Court, it was held that the very same preliminary agreement was not legally binding, which shows that parties cannot be too explicit in stating within these preliminary agreements an express condition as to whether or not an agreement is intended to be legally binding (Factory 5 Pty Ltd (In Liq) v State of Victoria (No 2) [2012] FCAFC 150 ).

In the event that your MOU or LOI is not binding, generally speaking, any breaches do not have legal consequences and it is up to the parties to resolve disputes. Having said this, these preliminary agreements are still of use. For example, in the event a party breaching the formal contract as you can use the MOU or LOI as evidence to support your position. Furthermore, following British Steel Corporation v Cleveland Bridge ad Engineering Co Ltd [1984] 1 All ER 504, consultants are more likely to be able to enforce their entitlement to payment of a reasonable sum for work done on the basis of a letter of intent.

It is prudent to make sure that you seek legal, insurance and commercial advice on any LOI you are entering into. If the project and relationship is of high risk with a lot at stake, you should consider whether a formal contract might be a more appropriate form to record the agreement.

The take-away

From a practical and risk management perspective, it is important to keep in mind that both MOUs and LOIs are temporary documents and should be replaced with a full formal contract before the project reaches any level of complexity or serious risk of disputes. For instance, allowing a head contractor to occupy the construction site and commence works based only on a letter of intent between principal and contractor would place the principal in a very risky position. We would also suggest that you try to formalize and sign the intended contract as soon as possible for a best risk management approach if you do enter into a MOU and LOI due to the variable nature of such agreements.

Remember that the document being titled as “MOU” or “LOI” does not, by itself, tell you whether it is a legally binding contract. When you receive an MOU or LOI, seek legal advice to determine and clarify whether or not this is intended to be binding, and make sure that this is noted in words within the relevant MOU or LOI. If the document is, or may be, legally binding, consider seeking insurance advice as you would for any other contract.

Felicity Dixon
Risk Manager

This article is only general advice in respect of risk management. It is not tailored to your individual needs or those of your business, nor is it intended to be relied upon as legal or insurance advice. For such assistance you should approach your legal and/or insurance advisors.

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